Down in the Weeds with the Pentagon’s Auditors

On the floor of the Senate last week, Republican Senator Chuck Grassley of Iowa continued banging the drum on what he calls weak oversight by the Defense Department Office of Inspector General and the Pentagon’s continuing challenges with achieving private sector-style accounting.

“This story is about a difficult audit where the inspector general apparently got a bad case of weak knees and caved under pressure,” Grassley said. “The inspector general dropped the ball on an audit that should be a critical component in Secretary Panetta’s effort to bring the Defense Department into compliance with the Chief Financial Officers (CFO) Act.”

His remarks were little noticed outside of the rarefied circles of Pentagon auditors and accountants. They essentially boiled down to whether or not the inspector general should have formally issued a report saying it didn’t agree with a private-sector auditing firm’s audit of a Pentagon agency’s financial statements (now you understand why it was little-noticed).

Annual financial statements are required by the CFO Act of 1990. While a handful of Defense Department agencies have received a thumbs-up (“unqualified” or “clean” audit opinions) from independent auditors who’ve examined their financial statements, most of the Pentagon and the Defense Department overall cannot produce financial statements that pass muster under current requirements.

This is what critics mean when they say the Pentagon doesn’t know where the money is going.

The Defense Finance and Accounting Service, or DFAS, has long received clean audit opinions on its financial statements. For instance, in late 2008, DFAS boasted that it “has received its ninth consecutive unqualified (clean) audit opinion from our independent auditors.” Those independent auditors are at Urbach Kahn & Werlin (UKW) and they have issued those audit opinions for the last decade, according to a Grassley staffer. The cost of those audits alone by UKW clock in at about $1 million per year.

But Grassley cast some doubt on this seemingly sterling record, and on the defense secretary’s new initiative to get the entire department in compliance with the CFO Act.

“The kingpin of his initiative — the department’s flagship accounting agency known as the Defense Finance and Accounting Service — may not be ready to produce credible financial statements,” Grassley said.

Enter the IG.

In February 2010, DFAS “claims to have earned a clean opinion” for its fiscal year 2009 financial statements, Grassley continued. “Yet when its financial statements were put under the inspector general’s microscope, they were found to be lacking. They did not meet prescribed audit standards.”

Now enter whistleblowers from inside the inspector general’s office. They came to Grassley, long a champion of dissenters from inside IG offices, because their negative take on UKW’s audit of DFAS’ statements was not published in writing.

“To make matters far worse, all the evidence suggests the inspector general may have quashed this negative audit report, allowing the charade to continue unchecked,” Grassley said. “This oversight failure could leave a gaping hole in Secretary Panetta’s master plan.”

The heart of the disagreement between the IG and the audit firm UKW was over its sample size. Auditors typically take a certain number of transactions and examine them closely, comparing them against what’s recorded in the financial statements. A sample size can vary depending on the assessed risk of the entity examined. For instance, a questionable entity with a history of accounting lapses and weak internal controls will typically get a closer and more extensive look from an audit firm — requiring a bigger sample size — than an entity with unvarnished history and strong controls. In any case, the sample size has to be big enough to be representative.

An IG letter to Grassley in response to his floor speech stated that, in its view, the audit firm “did not perform sufficient audit work on the Accounts Payable and Undelivered Orders accounts. Without performing additional work on these two material accounts, the DOD IG audit staff could not determine whether there were material misstatements.” (A Grassley staffer told me similar problems were found the year before when the IG examined UKW’s audit.)

However, the audit firm and DFAS disagreed with the IG and dug in. “The firm performed its audit in accordance with industry accepted audit standards, in conformance with the contract executed for this work and in compliance with DoD regulations,” DFAS said in a statement issued to Battleland. UKW, which officially changed its name several years ago to UHY Advisors, did not respond to a request for comment.

In response, the IG planned on issuing a “non-endorsement letter” on the firm’s audit.

Up to this point, Grassley was happy with the IG.

But then the IG decided not to issue a letter.

“Unfortunately, the inspector general dropped the ball and quit before the job was done,” Grassley said. “The inspector general’s report, known as a non-endorsement report, was finalized but never signed and issued. It was simply buried in a deep hole and covered up with dirt.” Grassley said it essentially only required a signature from a senior IG official.

The IG wrote to Grassley that “it is not accurate to state that the endorsement letter was completed and just needed to be signed.” Because of additional work required, they estimated that to issue the letter in accordance with auditing standards would delay the letter by two months beyond the four months it was already late. The IG stated it had already told DFAS it did not endorse the audit firm’s opinion and it didn’t matter what way its message was conveyed. “A formal letter of non-endorsement, ” the IG insisted, “would have provided little additional value to the Department.”

In summary:

— the IG believed a private firm’s audit didn’t meet auditing standards.— But it didn’t issue a document stating this because the IG says that would have required more work for the IG itself to meet auditing standards.— So the IG decided not to issue its opinion in written form.

Grassley thinks the argument that the letter would have required weeks of additional work is a “stretch.” Furthermore, he asked, “Is the inspector general implying that [IG senior official] Ms. [Patty] Marsh’s verbal non-endorsement announcement constituted de facto or unofficial non-endorsement? If that is indeed the case, then how come the central accounting agency still pretends to have earned a clean bill of health?”

There is a note of regret in the IG’s response to Grassley, and an implicit acknowledgment that it should have simply done the work and published the letter. “In hindsight, it would have been beneficial if the DoD IG could have completed the work necessary to support a non-endorsement letter,” the IG said. “Given the same circumstances today, the DoD IG would do things differently.”

The IG may have another chance. A Grassley staffer told me that Grassley wants the IG to review UKW’s latest audit opinion on DFAS.

But perhaps the biggest potential no-no in the whole episode were the payments DFAS made to UKW for its audit – and here no one is alleging that the IG did anything wrong. The IG, under the terms of the contract, had the ability to accept or reject UKW’s invoices for payment. IG contracting officers, on advice of the IG’s general counsel, rejected some of UKW’s invoices for its audit services for DFAS. But DFAS paid them anyway, according to a Grassley staffer.

“It is alleged…that DFAS payments to the CPA firm violated the terms of the contract and may have constituted improper or fraudulent payments,” the staffer said. “Those issues need to be addressed and resolved.”

Yet DFAS has denied the payments were improper. Based on information from the IG and UKW, “DFAS accepted the audit and authorized outstanding invoices for payment,” according to a DFAS statement.

Big deal or not?

“In the world of financial audits, it is not uncommon for some of the watchdogs to question the work of some of the other watchdogs,” emailed Christopher Hanks, a former defense analyst who worked at the RAND Corporation and the Institute for Defense Analyses, two of the top go-to think tanks funded by the Pentagon. “Senator Grassley is certainly justified, in any case, in wanting to learn more from the Deputy IG about what happened.”

But Hanks, author of an article critical of the appropriateness of most CFO Act requirements for federal agencies, said he believes the bigger picture is being missed by Grassley and by many members of Congress:

The real tragedy here is not that the DODIG at DOD is possibly being “undermined” in some way, but rather that the DODIG (and every other office at the DOD) is being distracted in wasteful ways by continuing Congressional demands for financial-statement reporting that has never made sense for a government agency (namely the DOD) that has always, and will always, run on budgets, not “profits.”

Whether or not Hanks is right, the CFO Act remains the law. With legislation such as Sen. Tom Coburn’s (R-Okla.) “Audit the Pentagon Act” likely to be reintroduced in the next Congress, this won’t be the last time taxpayers hear about the sad state of Pentagon bookkeeping.